Why has the Nordic electricity
market worked so well?
Elforsk rapport 05:25
Lars Bergman
June 2005
Why has the Nordic electricity
market worked so well?
Elforsk rapport 05:25
Lars Bergman
June 2005
Why has the Nordic electricity
market worked so well?
Elforsk rapport 05:25
ELFORSK
Foreword
The development of liberalized electricity markets around the world is, partly, an
experiment of applied market theory with uncertain outcome. For this new paradigm to
benefit customers thru efficient supply of electricity, we need increased and better
knowledge on how competitive electricity markets really work and how to solve the
problems that might occur.
The study documented in this report was carried out by Professor Lars Bergman of
Handelshögskolan in Stockholm, who also presented it at a seminar in San Francisco
earlier this year. It is a brief summary of the experiences and the functioning of the
Nordic electricity market.
In essence, Mr. Bergman’s study proves that the Nordic market seems to have worked
fairly well during its’ first ten years of operation. The need for further fine-tuning of the
market design is still there though and that is also one of the reasons that Elforsk will
continue its’ efforts for improving and exploring different issues related to market
design in the program carrying that very same name. Another reason to keep studying
the Nordic market is that various reforms are continuously proposed on an international
and EU-level. In the midst of this, it is our opinion that we must keep building on the
fundamentals that have worked well and also disseminate knowledge on this to the rest
of Europe and the world.
Elforsk is owned by the Swedish electrical utilities. Its’ business idea is to conduct
research and development considered appropriate by its’ owners and carry out this R&D
jointly and together with other parties. In 2000, Elforsk initiated the Market Designprogram for the purpose of supporting research on the functioning of competitive
electricity markets. The program is financed by Swedish utilities, EBL-Kompetanse in
Norway as well as the Swedish Energy Agency.
More information about the program, finished reports and conference documentation
can be found at www.marketdesign.se.
Stockholm, June 2005
Peter Fritz
Secretary of the Market Design-program
Elforsk AB
iv
ELFORSK
Table of contents
1
INTRODUCTION .................................................................................................. 1
2
CONSUMPTION, PRODUCTION AND MARKET STRUCTURE ................................ 2
3
REGULATORY FRAMEWORK AND MARKET DESIGN ........................................... 4
4
PRICES IN 2002-03: SIGNS OF MARKET POWER? ............................................... 6
5
WHY HAS THE NORDIC MARKET WORKED SO WELL? ........................................ 9
5.1
5.2
5.3
5.4
MARKET DESIGN AND HYDRO POWER ......................................................................... 9
DILUTION OF MARKET POWER .................................................................................. 9
POLITICAL SUPPORT ............................................................................................ 10
COMMITMENT TO PUBLIC SERVICE........................................................................... 10
6
CONCLUDING REMARKS .................................................................................. 11
7
REFERENCES ................................................................................................... 12
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1 Introduction
Between 1991 and 2000 the electricity markets in Denmark, Finland, Norway and
Sweden were opened up for competition in generation and retailing, and the four
national markets were integrated into a single Nordic electricity market. To a large
extent this development was induced by the first EU electricity market directive1 that
came into force in 19972. It also was inspired by the electricity market reform in
England & Wales in 1989, as well as by widely held beliefs that increased competition
would raise power industry efficiency to the benefit of consumers.
But there were also doubts about the blessing of electricity market reform. One fairly
common claim was that traditional vertical integration of generation and transmission
facilitated a high level of security of supply and gave rise to economies of scope that
were likely to exceed the efficiency increases resulting from competition in generation
and retailing. Another claim was that the major power companies were large enough to
be able to exercise market power and thus prevent much of the potential gains of
competition to be realized.
By now the general opinion among power industry representatives and electricity
market analysts is that the Nordic electricity market has worked well. The “lights have
stayed on” in spite of several adverse supply and demand “shocks”, and according to
available data power industry productivity has increased. Seemingly as a result of
increased competition both wholesale and retail profit margins have been squeezed.
However, very high wholesale prices in late 2002 and early 2003 may indicate the
exercise of market power. As will be discussed below, however, a careful analysis of
the developments in 2002 and 2003 does not support that view.
Yet the picture is not entirely rosy. In spite of the positive developments in terms of
continuous market clearing and increased power industry productivity the public at
large is less enthusiastic about the results of electricity market reform. Thus there are
frequent complaints about bills that are difficult to understand and administrative
problems in connection with change of retailer. Needless to say an important reason for
the limited general popularity of the electricity market reform is that retail electricity
taxes have increased to the extent that most households currently pay more for their
electricity than they used to do. However, the administrative problems are likely to be
temporary, and a political decision to raise electricity taxes is not, after all, a sign of a
badly functioning electricity market.
In view of this it seems that the Nordic electricity market, particularly the wholesale
market and related financial markets, has worked quite well. The purpose of this paper
is to explore why this is the case, and to what extent the Nordic experiences are relevant
for other countries. In other words, is the Nordic electricity a relevant role model for
other countries?
1
2
The first EU electricity market directive and its implementation are discussed in Bergman et.al. (1999).
The deadline for transcribing the directive into national legislation was in February 1999.
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2 Consumption, production and market structure
The total consumption of electricity in the Nordic countries is around 390 TWh per
annum, reflecting internationally very high per capita electricity consumption. For a
long time electricity consumption grew by more than 5 percent per annum, but after
1990 the rate of growth have been quite low (see Table 1). Thus competition in
generation has been introduced during a period when the need for new capacity was
low, and the room for entry of new generators thus quite limited.
Country
Denmark
Finland
Norway
Sweden
Total
OECD
Consumption
TWh
35
82
125
151
393
-
Annual growth 1990-2001
%
1.1
2.5
1.6
0.7
1.4
-
Consumption per capita
kWh
6 929
16 264
28 428
17 347
16 997
8 404
Table 2.1 Electricity consumption data for the Nordic countries 20013. Source: The Swedish
Energy Administration.
Around 50 percent of total power generation in the area is based on hydropower, but the
share of hydropower differs significantly between the four countries4. The high share of
hydropower, and the fact that electric heating is a major electricity consumption sector,
means that variations in climatic conditions may, and frequently do, cause supply or
demand “shocks”. Thus, since 1996 the annual variations in potential hydropower
production have been quite significant, and there have been spells with extreme loads
reflecting unusually cold weather conditions in the entire Nordic area.
Another aspect of the supply side of the Nordic electricity market is the number and
relative size of the power companies. As can be seen in Table 2 a few major power
producers have a dominating position on their respective national markets. At the same
time none of them has a share of the Nordic market that exceeds 20 percent. This
suggests that the degree of competition to a very large extent depends on the degree of
integration of the four national markets, which in turn depends on inter-connector
capacities and institutional barriers to trade between the four countries.
Company (Country)
Vattenfall (Sweden)
Fortum (Finland)
Statkraft (Norway)
Sydkraft (Sweden)
Share of national market
%
47
29
27
19
Share of Nordic market
%
17
14
9
8
Table 2.2 Power producers and market share. Source: The Swedish Energy Administration.
3
International per capita consumption data for a later year are not available. However, in the Nordic
countries electricity consumption went down to a total of 380 TWh in 2003.
4
The share of hydropower varies significantly between the four countries, and is close to 100 percent in
Norway, around 50 percent in Sweden, around 15 percent in Finland and zero in Denmark.
2
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Public ownership is still dominating in the Nordic countries. Thus Vattenfall is owned
by the Swedish state and Statkraft by the Norwegian state. Fortum is in the midst of a
privatization process, with the Finnish state still being a big minority owner. Sydkraft is
owned by the German power company E.ON with the Norwegian state being a big
minority owner.
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3 Regulatory framework and market design
The overall design of an electricity market has three fundamental components: The
regulatory framework, the trading arrangements, and the design of transmission tariffs.
In this section the Nordic electricity market will be briefly described from these three
points of view, beginning with the regulatory framework.
In Table 3 the regulatory framework in the Nordic countries is described using the
criteria and requirements5 of the first EU electricity market directive. Needless to say
the electricity market is regulated in many other ways, but the basic regulations adopted
by the EU are crucial for the creation of a competitive electricity market. In particular
third party access to the network infrastructure is a key prerequisite for a competitive
electricity market.
As can be seen in the table the EU directive allowed the individual member states to
choose between two or more alternatives. However, the Nordic countries have in
general chosen the alternatives that are most likely to foster a competitive electricity
market. Thus regulated third party access (rTPA) is likely to foster a competitive
electricity market more than a regime with negotiated third party access (nTPA) would
do. In the same way an authorization procedure probably stimulates competition in
generation more efficiently than a regime with tendering for new generation would do.
Table 3. Basic regulatory framework
Denmark
Finland
Norway
Sweden
EU
Directive
New generation Unbundling of gene- Third party access Market
opening
procedure
ration, transmission
and distribution
Authorization
Accounting and manrTPA
100%
agement separation
Authorization
Legal separation
rTPA
100%
Authorization
Accounting and manrTPA
100%
agement separation
Authorization
Legal separation
rTPA
100%
Authorization or Accounting and man- Regulated (rTPA),
30 %
Tendering
agement separation as Negotiated (nTPA)
a minimum
or Single Buyer
Table 3.1 Basic regulatory framework.
The key trading institution in the Nordic electricity market is the Nord Pool power
exchange, which is an “energy only” spot market at which hourly “system prices” are
determined in single price auctions. As long as transmission capacity is sufficient the
system price is equal to the wholesale trading price in all four countries. But whenever
lack of transmission capacity prevents cross-border trade the “area prices” differ from
the system price. Norway is divided into several “price areas”, while there is only one
price area in Finland, Sweden and the two parts of Denmark6, respectively.
5
6
For a detailed discussion of these criteria and requirements see Bergman et.al. (1999).
There are two separate electricity supply systems in Denmark, East and West.
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Nord Pool also operates financial (forwards, futures and options) markets at which
generators and major buyer can hedge system price risks. The system operator in each
one of the countries operates a real time market in order to continuously balance
generation and load at minimum cost. In all the four countries the system operators also
manage bottlenecks within the respective country and between the countries by means
of a counter-trade system.
Transmission tariffs are designed in largely the same way in the four countries. A key
feature is that transmission prices are independent of the geographical distance between
trading parties. As there are no border tariffs between the Nordic countries, the physical
inter-connector capacity constraints are the only remaining barriers to trade across the
national borders
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4 Prices in 2002-03: Signs of market power?
Until the summer of 2002 the Nordic electricity market seemed to be a success (see
Bergman (2002)). Since 1996, when the Norwegian and Swedish markets were
integrated, security of supply had been maintained7, and wholesale prices had fallen
considerably. Both industrial and household customers had benefited from the lower
prices, even though Swedish household customers had been faced with higher taxes on
electricity.
Spot price
05.09.03
20.07.03
03.06.03
17.04.03
01.03.03
13.01.03
27.11.02
11.10.02
25.08.02
09.07.02
23.05.02
06.04.02
18.02.02
900
800
700
600
500
400
300
200
100
0
NOK/MW
h
100
90
80
70
60
50
40
30
20
10
0
02.01.02
Per cent
However, between 1997 and 2001 the supply of hydropower was well above normal,
particularly in 2000. In 2002 the situation changed, and the second half of that year was
an exceptionally dry period, and the inflow to hydro reservoirs was only around 50
percent of average inflow during the last 20 years. As a result the hydro stocks were
extremely low at the beginning of the winter season when most precipitation comes in
the form of snow and thus does not add to the reservoirs until the spring period. In view
of this hydropower producers reduced supply, and spot market prices reached
unprecedented levels (see Figure 1). But the high prices “did their job” in the sense that
the market continuously cleared8.
Hydro stocks
Figure 4.1 Spot price and Norwegian hydro stock, 2002-2003. Source: Statistics Norway and
Norwegian Water and Energy Authorities.
Needless to say continuous market clearing, implying that electricity always can be
bought or sold at the prevailing price, is an extremely important feature of a market for
electricity. But from a social point of view it is also very important that the market
prices reflect the relevant marginal costs. This is the case if external effects are
effectively internalised, and if the market is sufficiently competitive. Here we focus on
the latter aspect, i.e. whether the observed prices to any significant degree reflect the
exercise of market power by major generators.
7
However, the margin between available capacity and peak load has gradually decreased, and concerns
for the security of supply have increased. In response to these concerns the system operators in Norway
and Sweden have introduced incentives for generators to keep reserve capacity available during peak
periods.
8
For a detailed discussion of the market developments in 2002-03 see von der Fehr et.al. (2005).
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In a system dominated by hydropower exercise of market power is not easy to detect. At
any given time a generator has to decide whether to use or continue to store a unit of
water in the reservoir. The choice depends on factors such as the expected precipitation
before and during the next winter season, the length of the winter season and the
expected demand during the period. This means that an outside observer cannot easily
judge whether a given reduction of hydropower production reflects exercise of market
power or just conservative expectations about climatic conditions during the coming
months. One way of getting around this problem is to use a simulation model.
In this study a simulation model, PoMo9, of the Nordic electricity supply system has
been used. PoMo is a dynamic optimization model that computes weekly equilibrium
prices under the assumption the Nordic electricity market is competitive and that
generators are risk neutral. In any given week generators are assumed to know the
current stock of water in the reservoirs, demand, and the output of electricity from
nuclear, fossil and wind power plants. They are also assumed to know the probability
distribution for the future weekly inflow of water to the reservoirs, as well as for the
future weekly demand and non-hydro generation. The time horizon is three years.
Altogether these assumptions imply that PoMo to a large extent depicts the situation
faced by the generators making production decisions and selling power on the Nord
Pool spot market during a given week. Deviations between computed PoMo prices and
observed Nord Pool prices for a given week obviously reflect various shortcomings of
the model. But as PoMo assumes that the Nordic electricity market is perfectly
competitive, the deviations also reflect the impact of market power.
In Figure 2 the actual spot market prices (weekly averages) and the corresponding
PoMo prices in the second half of 2002 and the first half of 2003 are compared. The “12
TWh” case is a PoMo simulation in which the minimum amount of stored water is
allowed to be 12 TWh rather the standard requirement 15 TWh. As the minimum
requirement was in fact reduced to 12 TWh the beginning of 2003 this case is the most
realistic of the two PoMo cases in the figure.
A comparison of the “Nord Pool” and “12 TWh” price paths suggest that real world
producers react earlier than the risk neutral PoMo producers. Thus Nord Pool prices
increased earlier and exceeded the PoMo prices at the end of 2002, but from the
beginning of 2003 the situation was reversed. A possible explanation to this deviation is
that real world generators are risk-averse and thus overly fast to reduce hydropower
production when the risk of running out of water before the spring period is perceived
to be high.
9
PoMo is developed by EME Analys and Tentum, and frequently used by the Swedish National Energy
administration.
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PoMo - NordPool
1200
SEK/MWh
1000
PoMo
NordPool
12 TWh min
800
600
400
200
16
13
10
7
4
1
50
47
44
41
38
35
0
Week
Figure 4.2. Comparison of actual and simulated prices 2002-2003.
However, if the major power companies had been exercising market power, the Nord
Pool prices would have exceeded the PoMo prices during the entire period. Thus the
simulation results suggest that the Nordic electricity market is quite competitive, with
market clearing prices close to the relevant marginal costs. The high prices 2002-03
simply reflected an unusual scarcity of hydropower combined with the usual low
elasticity of demand.
8
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5 Why has the Nordic market worked so well?
Most consumers expect the electricity market to work well and they pay no attention to
the reasons why that is the case. In a somewhat wider context, however, that issue is
important. If the relative success of the Nordic market is due to a good design of
regulations and market institutions, then the Nordic experiences are useful for other
countries. But if the favourable outcome primarily depends on country-specific factors
or temporary circumstances, there is not much for other countries to learn.
On the basis of my own and other studies of the topic my conclusion is that there are
four main factors behind the relatively successful electricity market reform in the
Nordic countries, namely:
• A simple but sound market design, to a large extent made possible by the large
share of hydropower.
• Successful dilution of market power, attained by the integration of the four
national markets into a single Nordic market.
• Strong political support for a market-based electricity supply system.
• Voluntary, informal commitment to public service by the power industry.
The second and third of these factors are “transferable”, while the first and fourth to a
large extent are country-specific. In the following each one of the four factors will be
briefly discussed.
5.1 Market design and hydro power
Electricity supply systems dominated by hydropower tend to be energy-constrained
rather than capacity-constrained. Thus the need for incentives to maintain sufficient
peak capacity is much smaller than in systems based on fossil fuelled power plants.
Moreover, contrary to fossil fuelled power plants hydropower plants have negligible
start-up costs. Thus the cost of production during a particular hour does not depend on
the rate of production during adjacent hours. Altogether this means that hourly trading
on a power exchange, such as the Nord Pool spot market, to a very large extent provides
the right incentives for efficient allocation of resources in the power industry.
The designers of the Nordic “model” obviously have benefited from the fact that around
50 percent of Nordic power production is based on hydropower. But they were not just
lucky. They also actively contributed to an efficient market design by not imposing
price regulations or other regulations that would have increased the transaction costs or
financial risks carried by generators, industrial customers and retailers.
5.2 Dilution of market power
Like in most other European countries the national electricity markets in the Nordic
area were all dominated by a publicly owned “national champion”. This was
particularly the case in Sweden where the market share of the state owned company
Vattenfall was more than 50 percent. Given the new regulatory framework the major
companies would be able to exercise considerable market power on their respective
home market and thus jeopardize the competitive electricity markets that the reforms
were intended to create.
The strategy adopted to solve this problem was market integration. Again thanks to the
large share of hydropower, in conjunction with the uneven distribution of hydropower
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resources between the four countries, inter-connector capacities were quite large. Thus
the barriers to cross-border trade were institutional rather than physical. By abolishing
border tariffs and adopting a system with distance-independent transmission prices the
relevant market was significantly enlarged and the market power of the major
generators diluted.
However, from time to time the physical inter-connector constraints are binding so that
the Nordic market becomes two or several regional markets with different prices. With
the exception of 2000, when inter-connectors from Norway were congested most of the
time, there has been complete price equalisation between 30 and 60 percent of the time
and only small price differences during most of the remaining time. The Swedish
electricity market has been fully integrated either with the Finnish or the Norwegian
market essentially all the time. Thus from a competition point of view the Nordic
electricity market is close to a single market in which the combined market share of the
four major producers is less than 50 percent (see Table 2).
5.3 Political support
Even though electricity market reform came about as a result of political decisions
continued political support by no means is guaranteed, particularly if employment in the
power industry is reduced as a result of increased competition or supply and demand
shocks lead to high electricity prices. In the Nordic countries the development of prices
in 2002-03 was a major test of the degree of political support for the market based
electricity supply system. Although there were strong demands for political
intervention, particularly in Norway, no intervention took place.
Thus, instead of blaming the power companies leading politicians stated that electricity
prices were high because hydropower was unusually scarce, and that no regulation
could change that situation to the better. Apart from the fact that no regulations,
temporary or permanent, were imposed the no-intervention policy probably also had
long-term effects. Due to annual variations in hydropower supply wholesale electricity
prices inevitably will vary between different years. By confirming that prices will be
allowed to be high in “dry” years the politicians in effect increased the expected rate of
return on investments in new generation capacity.
5.4 Commitment to public service
Although the power companies in the Nordic countries have been exposed to
competition for quite some time a strong commitment to public service seems to remain.
Alternatively there may be expectations that collusion and exploitation of market power
will induce new regulations or even a return to the “old” system. In any case an analysis
of the development of electricity prices give no indication that there is collusion
between generators, or that major power companies exploit the market power that they
in fact have. Thus actual wholesale electricity prices have constantly been lower than
the prices obtained in simulations with numerical oligopoly models in which Cournot
competition is assumed (see Bergman (2002)).
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6 Concluding remarks
There are two major threats to the success of electricity market reform in the Nordic
countries. The first is that security of supply can not be maintained. The second is that
market power prevents the potential benefits of competition to be realized. So far
security of supply has been maintained, although exceptional storms have created
serious problems in electricity distribution. The major power companies have been
accused of exercising market power, but convincing proofs are lacking. At the same
time power industry productivity has increased, and retail electricity prices (before tax)
have become strongly linked to wholesale electricity prices.
The situation may change in the future. Thus it remains to be seen that investments in
new capacity are carried out when they are needed, and that mergers and capacity
expansion do not significantly increase concentration and market power. But the
development of the Nordic electricity market so far to a large extent is quite successful.
Does this mean that the “Nordic model” should be adopted all over the world?
The answer is “no”. In many ways the success of the Nordic model depends on area
specific factors such as ample supply of hydropower and significant inter-connector
capacities. Yet there are some “universal” lessons that can be learned from the Nordic
experiences. In particular the Nordic experiences suggest that a “deregulated” market
for electricity works well if:
• There are no price regulations and constraints on the development of financial
markets
• There is continued political support for a market based electricity supply system
also when electricity is scarce and prices are high.
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7 References
Bergman, L., G. Bruunekreft, C. Doyle, N-H M. von der Fehr, D.M. Newbery, M.
Pollitt and P.Regibeau (1999) “A European Market for Electricity”. Monitoring
European Deregulation 2. London: CEPR and SNS.
Bergman, L. (2002), “The Nordic electricity market – continued success or emerging
problems?” The Swedish Economic Policy Review, Vol. 9, 11-38.
Von der Fehhr, N-H M., E.S. Amundsen and L. Bergman (2005), ”The Nordic Market:
Signs of Stress?”, The Energy Journal, Special Issue on European Energy
Liberalisation.
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